Tapering might start later than many expect, says JP Morgan’s Sara Yates

Sara Yates, vice president – global FX strategist at JP Morgan Private Bank, comments on the performance of international markets after the US Federal Reserve’s statement of last week.

As of last Friday’s close Bloomberg reported that the Greenback outperformed all but the Hong Kong Dollar and 18 frontier currencies, such as the Somali Shilling and Nigerian Naira on the week.

The main reason for the USD’s triumph was the dramatic rise in US yields following the Federal Open Market Committee (FOMC) statement and Bernanke’s press conference. At the time of writing, 10y US Treasury yields are above 2.5%. For a bond, this is a substantial move from the 2.15% where they started the week.

What caused the dramatic move higher in US yields was primarily the more hawkish tone from the FOMC statement, forecasts and Bernanke’s press conference. In its statement, the FOMC upgraded its assessment of the labour market by stating it had shown “further improvement”.

This improvement was mirrored in the forecasts, which showed the FOMC saw the economy expanding at a faster rate over the next two year than it had forecast in March as well as expecting the unemployment rate to fall quicker.

Crucially, the new forecasts for unemployment suggested the unemployment would fall to 6.5-6.8% in 2014 and below 6.5% in 2015. By
forecasting a rate of unemployment below 6.5% (the rate the FOMC has previously highlighted as being a potential turning point for the zero interest rate policy) it opened the door to near term rate hikes in the eyes of the market.

As a result, both short term and longer dated US yields (and the USD) rallied on their publication.
Thirty minutes after the statement and forecasts were released, Bernanke conducted his press conference.

Here too there was a hawkish slant. In particular, Bernanke suggested that not only would tapering commence later in 2014, but that it could be completed by the end of 2015. While Barclays Global Macro Survey suggested that over 70% of the investors they surveyed expected tapering to begin this year, the pace of tapering suggested by Bernanke is likely to be quicker than many thought. However, it was not all hawkish.

First, Bernanke continued to highlight the reliance on domestic data continuing to firm for this path to be followed. Many in the market continue to think the FOMC’s new forecasts are rather optimistic. This suggests the risk that tapering will start later than many now expect. Second, he emphasized that the 6.5% is a “threshold not a trigger”, hinted that the 6.5% threshold could be lowered and raised his concern about inflation being too low.

Taken together these comments cast substantial doubt on whether the Fed will step away from its zero rate policy over the next two years. Perhaps more important, if it means that US rates will stay historically low at the same time as unemployment falls and growth improves, it should be a great environment for the USD AND selective risk on currencies.

US yields are typically set as the benchmark rate in the market. The higher they go relative to other markets, the less attractive other
markets become. Consequently, the recent rise in US yields has prompted the market to consider the appropriateness of its non US exposure. This has been particularly so in emerging markets due to the market’s extended positioning.

As we continue to believe there is limited further upside for US yields at this point, we continue to believe a dramatic re-pricing of global risk premia and a structural change in portfolio holdings is unlikely just yet. Consequently, we continue to expect markets to stabilise and take comfort from the fact that outflows (as recorded by EPFR’s flow data) as tiny as a percentage of assets under management. However, as long as US yields are moving higher, emerging market currencies with a “hands off” central bank are likely to remain under particular pressure.

As mentioned at the start, it is not just emerging market currencies that are underperforming the USD. G10 currencies also remain under pressure. Of these, we continue to believe the AUD, CHF and JPY are likely to underperform the most. Even after the recent sell off, the AUD remains an expensive currency with deteriorating fundamentals. It is also the currency most exposed to the on-going slowdown in China.

The CHF too is very expensive as it does well in a world of heighten risk aversion. And while the market may be nervous at the moment as it considers its portfolio holding against a stronger US economy, a stronger US economy is a long term positive for risk appetite.

As markets stabilise and US yields remain supported, we expect USDCHF to appreciate. In contrast to the previous two, the JPY is a cheap currency. However, we expect it to cheapen further, as we expect Abe to win control of the UpperHouse and use this reinforced mandate to drive forward needed reforms in Japan.

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